Simple ways to invest in Real Estate
Basic Rental Properties This is an investment as old as the practice of landownership. A person will buy a property and rent it out to a tenant. The owner, the landlord, is responsible for paying themortgage, taxes and costs of maintaining the property. Ideally, the landlord charges enough rent to cover all of the aforementioned costs. A landlord may also charge more in order to produce a monthly profit, but the most common strategy is to be patient and only charge enough rent to cover expenses until the mortgage has been paid, at which time the majority of the rent becomes profit. Furthermore, the property may also have appreciated in value over the course of the mortgage (according to the U.S. Census Bureau, real estate has consistently increased in value since 1940), leaving the landlord with a more valuable asset. (To learn more, read Paying Off Your Mortgage and Understanding Your Mortgage.)
There are, of course, blemishes on the face of what seems like an ideal investment. You can end up with a bad tenant who damages the property or, worse still, end up having no tenant at all. This leaves you with a negative monthly cash flow, meaning that you might have to scramble to cover your mortgage payments. There is also the matter of finding the right property – you will want to pick an area where vacancy rates are low (due to demand) and choose a place that people will want to rent.
Perhaps the biggest difference between a rental property and other investments is the amount time and work you have to devote to maintaining your investment. When you buy a stock, it simply sits in your brokerage account and (hopefully) increases in value. If you invest in a rental property, there are many responsibilities that come along with being a landlord. When the furnace stops working in the middle of the night, it’s you who gets the phone call. If you don’t mind handyman work, this may not bother you; otherwise, a professional property manager would be glad to take the problem off your hands – for a price, of course. (For further reading, see Tips For The Prospective Landlord.)
Real Estate Investment Groups Real estate investment groups are sort of like small mutual funds for rental properties. If you want to own a rental property, but don’t want the hassle of being a landlord, a real estate investment group may be the solution for you. A company will buy or build a set of apartment blocks or condos and then allow investors to buy them through the company (thus joining the group). A single investor can own one or multiple units (self-contained living space), but the company operating the investment group collectively manages all the units - taking care of maintenance, advertising vacant units and interviewing tenants. In exchange for this management, the company takes a percentage of the monthly rent.
There are several versions of investment groups, but in the standard version, the lease is in the investor’s name and all of the units pool a portion of the rent to guard against occasional vacancies, meaning that you will receive enough to pay the mortgage even if your unit is empty. The quality of an investment group depends entirely on the company offering it. In theory, it is a safe way to get into real estate investment, but groups are vulnerable to the same fees that haunt the mutual fund industry. Once again, research is the key.
Real Estate Trading This is the wild side of real estate investment. Like the day traders who are leagues away from a buy-and-hold investor, the real estate traders are an entirely different breed from the buy-and-rent landlords. Real estate traders buy properties with the intention of holding them for a short period of time (often no more than three to four months), whereupon they hope to sell them for a profit. This technique is also called flipping properties and is based on buying properties that are either significantly undervalued or are in a very hot market.
Pure property flippers will not put any money into a house for improvements – the investment has to have the intrinsic value to turn a profit without alteration or they won’t consider it. Flipping in this manner is a short-term cash investment. If a property flipper gets caught in a situation where he or she can’t unload a property, it can be devastating because these investors generally don’t keep enough ready cash to pay the mortgage on a property for the long term. This can lead to continued losses for a real estate trader who is unable to offload the property in a bad market.
A second class of property flipper also exists. These investors make their money by buyingreasonably priced properties and adding value by renovating them. This can be a longer-term investment depending on the extent of the improvements. The limiting feature of this investment is that it is time intensive and often only allows investors to take on one property at a time.
REITs Real estate has been around since our cave-dwelling ancestors started chasing strangers out of their space, so it’s not surprising that Wall Street has found a way to turn real estate into a publicly-traded instrument. A real estate investment trust (REIT) is created when a corporation (or trust) uses investors’ money to purchase and operate income properties. REITs are bought and sold on the major exchanges just like any other stock. A corporation must pay out 90% of its taxable profits in the form of dividends to keep its status as an REIT. By doing this, REITs avoid paying corporate income tax, whereas a regular company would be taxed its profits and then have to decide whether or not to distribute its after-tax profits as dividends.
Much like regular dividend-paying stocks, REITs are a solid investment for stock market investors that want regular income. In comparison to the aforementioned types of real estate investment, REITs allow investors into non-residential investments (malls, office buildings, etc.) and are highly liquid – in other words, you won’t need a realtor to help you cash out your investment. (For further reading, check out What Are REITs?, Basic Valuation Of A Real Estate Investment Trust (REIT) and The REIT Way.)
Leverage With the exception of REITs, investing in real estate gives an investor one tool that is not available to stock market investors: leverage. If you want to buy a stock, you have to pay the full value of the stock at the time you place the buy order. Even if you are buying onmargin, the amount you can borrow is still much less than with real estate. Most “conventional” mortgages require 25% down. However, depending on where you live, there are many types of mortgages that require as little as 5%. This means that you can control the whole property and the equity it holds by only paying a fraction of the total value. Of course, your mortgage will eventually pay the total value of the house at the time you purchased it, but you control it the minute the papers are signed.
This is what emboldens real estate flippers and landlords alike. They can take out a second mortgage on their homes and put down payments on two or three other properties. Whether they rent these out so that tenants pay the mortgage or they wait for an opportunity to sell for a profit, they control these assets despite having only paid for a small part of the total value. (For more on taking out a second mortgage, read The Home-Equity Loan: What It Is And How It Works and Home-Equity Loans: The Costs.)
Conclusion We have looked at several types of real estate investment. However, as you might have guessed, we have only scratched the surface. Within these examples there are countless variations of real estate investments. As with any investment, there is much potential with real estate, but this does not mean that it is an assured gain. As with any investment, make careful choices and weigh out the costs and benefits of your actions before diving in.
Foreigners Buying and Selling U.S. Real Estate
As South Florida continues to emerge as a hub for international business, the influx of foreigners purchasing real estate has increased dramatically. That being said, there are many factors that foreign buyers need to be aware of, especially when it comes to navigating through U.S. tax rules and regulations. In addition to a basic understanding of American real estate terminology, such as escrow and title insurance, special tax rules also apply, making tax advice not just necessary, but imperative to avoid common pitfalls. Common Pitfalls One of the most common crossroads faced by foreign buyers of U.S. real estate is deciding how to take title of the property being purchased. The obvious answer is “in my own name,” but there are many variables to consider in structuring your U.S. real estate acquisition. If foreign buyers do take title in their name, the good news is that when they decide to sell their property, the gain will be taxed at the long-term capital gains rate of 15 percent, assuming the property was held for more than a year. However, when it comes to estate taxes, the foreign buyer who holds the title in his name is taking a significant risk because if he passes away while owning U.S. real estate, the entire value in excess of $60,000 is going to be subject to a tax at rates as high as 45 percent. For U.S. tax residents, green card holders and American citizens, it’s a different story. The current standard exemption for U.S. citizens and resident aliens is $2 million. So if the value of their assets is less than $2 million at the time of death, they will not be subject to the U.S. estate tax. Also, the U.S. citizen and green card holder can pass on all assets to their spouse’s estate tax-free. There are additional risks surrounding foreigners owning rental property. Anyone who owns U.S. real estate that is operating as a rental property is entitled to take a tax deduction for depreciation, mortgage interest, property taxes, expenses of management and repairs, etc. The benefit is that income tax is only paid on the net rental income, assuming that there is a profit after the deduction of all of the rental expenses. Net Election Foreign owners of U.S. rental property face a more complex issue. As long as they file their income taxes to report the rental activity (income or loss) in a timely manner, they are entitled to make a special election called the “net election.” This election allows them to report the rental income net of all property related expenses (interest, taxes, maintenance, depreciation, etc.). However, if a non-U.S. person does not file their income taxes timely, they lose the opportunity to make the “net election” and will be subject to a federal income tax of 30 percent of the gross rent with no deduction for any business expenses. So a foreign owner of U.S. rental real estate who has not been filing his tax returns because he is losing money and does not see the value or need to file annual income tax returns is in for a rude awakening. Even worse, when they sell their real estate, they will not be entitled to use any of those prior losses to reduce the gain on sale since they were not properly reported to the IRS. This is a harsh law but it is how the IRS enforces tax compliance. Foreign Investment Real Property Tax Act There are a many tax issues facing the foreign buyer of U.S. real estate. Yet, with proper tax planning and compliance taking into consideration both income tax and estate tax issues, the result can and will be tax efficiency and ultimately a greater return on your investment. On the flip side, selling real estate in the U.S. presents another set of rules. Similar to purchasing real estate, there are many variables and rules that nonresidents need to be aware of in order to avoid common pitfalls. The overriding law is FIRPTA, the Foreign Investment Real Property Tax Act. Under FIRPTA, when a foreign person sells their U.S. real estate, the closing agent or title company will deduct and withhold 10 percent of the gross sales price from his/her proceeds and send it to the Internal Revenue Service. Congress created FIRPTA as a way to prohibit foreigners from taking profits made from the sale of their U.S. real estate back to their native county without paying U.S. income taxes. The 10 percent withholding is intended to ensure that the IRS collects the income tax upon disposition of such interests. Whether a property is residential or commercial, parties involved with the sale, such as a title company or closing agent (usually an attorney), are required to ask about whether or not the seller is a foreign person. And because the U.S. differs from many foreign countries by integrating immigration and tax status, it is extremely important to understand how FIRPTA defines a foreigner to avoid confusion. According to FIRPTA, a nonresident alien individual is defined as a person who is neither a U.S. citizen nor a resident of the United States. The code bases this on two tests: the green card test and the substantial presence test. The green card test states that once an individual receives their green card, they are deemed to be a resident of the United States and will be taxed on his or her worldwide income, the same as a U.S. citizen. Under the substantial presence test, a foreign individual will be considered a resident for U.S. federal tax purposes if he or she is physically present in the U.S. for 183 days or more during the current calendar year. If the seller does not have a green card, is not a U.S. citizen and does not meet the substantial presence test, then he or she will be subject to the FIRPTA withholding. The closing agent has 20 days after closing to report and pay the tax to the IRS on Form 8288. If the seller determines that the 10 percent FIRPTA withholding is more than their true tax liability, they have the option of filing an application with the IRS to request a reduced withholding. If all of the information is properly presented to the IRS, the IRS will generally comply and reduce the amount to be paid by the withholding agent. The balance can then be returned to the seller. There are exceptions to be aware of as well. The most common one is that if the buyer purchases the property with the intent of using that property as their primary residence and the sales price is less than $300,000, no withholding is required. The buyer must plan to reside at the property for at least 50 percent of the number of days the property is used by any person during each of the first two 12-month periods following the date of purchase. Although there are many rules and regulations pertaining to the sale and disposition of property in the U.S., they don’t have to be confusing. Whether you are buying or selling, consult with a tax professional as well as a real estate attorney to ensure that you do not make any expensive mistakes.
